Diversify Your mREIT Portfolio

As investors and savers battle with financial repression, market participants have acquired high yielding securities. A popular asset class over the last few years has been mortgage real estate investment trusts. Mortgage REITs take advantage of a tax status to invest in mortgage related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage-backed securities. REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends.

Mortgage REIT Business Model

A mortgage REIT's principal business objective is to generate income for distribution to its stockholders from the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities. In addition, most mortgage REITs utilize significant leverage to boost shareholder returns. Many mREITs trade around book value and generate 12% - 15% annual yields. Sounds like a great opportunity, so what is the catch?

Understanding the Risks

Mortgage REIT investors must assess two major risks when investing in mortgage REITs: interest rate risk and prepayment risk. Mortgage REITs are highly levered investment vehicles that are sensitive to rises in short-term in interest rates. With a borrow short, lend long business model a rise in short-term rates can impact profitability. In addition, mortgage refinancing damage securities that trade for more than face value by returning principal faster at par and curbing interest.

Interest Rate Risk

Due a weak economic outlook and stubbornly high unemployment rates, interest rates will likely remain low for quite some time. Despite comments this week about a lack of additional QE, any future increases in interest rates will likely be well telegraphed by the Federal Reserve and beyond 2014.

Despite the markets misgivings over interest rate policy and the low 10 year Treasury I believe a diversified approach to mortgage REITs remains appropriate. Rates are unlikely to shoot higher in the near term due to significant macroeconomic and geopolitical headwinds:

Stubbornly high unemployment;

Ongoing European debt crisis;

Slowdown in China;

Backlog of foreclosed homes pressuring price;

Uncertainty surrounding tax policy;

Uncertainty created by the general election; and

Weakening U.S. economic data.

Prepayment Risks

According to eMBS prepayment rates have stabilized at a higher level over the last few months. The chart below outlines the increase in prepayment rates for agency mortgage back securities.

(click to enlarge)

While higher interest rates are unlikely to pose a real risk in the next few years, investors should closely monitor prepayment speeds. Mortgage REIT investors should focus on conditional prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The CPR reflects the percentage of principal that is prepaid over a period of time on an annualized basis.

As CPRs increase, the company will have to invest in securities with lower coupons, which will hurt earnings. Mortgage REITs are highly levered investment vehicles, which employ significant leverage to generate yields.

While higher interest rates are unlikely to pose a real risk in the next few years, investors should closely monitor prepayment speeds. Mortgage REIT investors should focus on conditional prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The CPR reflects the percentage of principal that is prepaid over a period of time on an annualized basis.

As CPRs increase, the company will have to invest in securities with lower coupons, which will hurt earnings. Mortgage REITs are highly levered investment vehicles, which employ significant leverage to generate yields.

Agency Securities vs. Non Agency or Hybrid Securities

Mortgage REIT managers typically focus on an agency or hybrid strategies. Agency REITs carry limited credit risk as securities are guaranteed by government sponsored entities. Agency REITs are subject to interest rate and refinance risk. As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders. Purchased at the appropriate price, non-agency securities can offer REIT investors attractive risk adjusted returns and lower the volatility in a REIT portfolio. Non-agency mortgages trade more like equity than credit as when the economy heals, recoveries increase. As the economy heals the market drives interest rates up which hurt agency securities.

A Diversified Approach

Most mortgage REITs trade around book value. Instead of trying to pick a winner I advise investors to buy a broad, diversified portfolio of agency and hybrid mortgage REITs.

While deploying the same basic borrow short, lend long thesis, M REIT strategies can vary. Annaly and American Capital Agency are agency REITs that are focused on fixed rate securities while MFA and Two Harbors are hybrid REITs that invest in distressed non-agencies and agencies. Below I have outlined by favorite REITs. In my view you are buying managers that deploy a specific strategy. Given that dividend yields are typically low to mid teens I advise a broad and diversified portfolio with your capital allocated to mREITs.

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